Here is just a quick reminder that everything you do has consequences in option trading. In other words, everything is essentially a risk/reward trade-off. Just think about it for a second: If you give up potential profit, you get a better risk/reward and vice versa. Let me go through an example with you below.
Suppose a stock you are watching has some potential support around the $130 level. At the time, the stock was trading around $132. An option trader could sell a put credit spread and know the odds are on his or her side to profit because the stock could move higher, trade sideways or move a little lower. In any of those three cases, the trade can profit so it makes sense the trade should have a greater risk than reward.
In the chart above, the 130 put was sold and the 128 put was purchased creating the credit spread. Max profit is the credit received, which in this case is 0.60 (2.35 – 1.75). The risk on the trade is 1.40 (2 [diff in strikes] – 0.60 [credit]). The delta on the short put is about 0.39. which means the odds of that put expiring worthless using the “option trader’s” definition of delta is 61% (1 – 0.39). Clearly the odds are on the option trader’s side so there is greater risk.
But what if the spread was lowered? Now the odds are even more on the option trader’s side but the risk is even greater and the reward smaller. Take a look at the chart below.
If the spread was lowered and the 126 put was sold and the 124 put was bought, the credit and max profit would be 0.33 (1.26 -0.93). The max risk goes up to 1.67 (2 [diff in strikes] – 0.33 [(credit]). The delta on the short put is about 0.23, which means the odds of the options expiring worthless is about 77% (1 – 0.23). The trade has more wiggle room but it comes with a greater risk and a smaller profit potential than the 128/130 put spread.
This was just one example and in future blogs we will discuss more. Just remember, there is always going to be a risk/reward trade-off in options trading.
Senior Options Instructor
Market Taker Mentoring, Inc.